Tuesday, December 6, 2022

Alphabet Unleashes Next Growth Driver

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Alphabet (GOOG)(NASDAQ:GOOGL) is rapidly increasing the size of its hardware business by adding new devices and increasing the market share of the current hardware products. It is already in a strong second position within the smart speaker and smart home devices segment, behind Amazon (AMZN). Despite the efforts of Apple (AAPL) to increase its market share, Google has been able to retain its hold over smart home devices. Google has also announced doubling production of its current Pixel smartphones due to better demand.
The growth of Google’s hardware business will help the subscription business. The company has already launched Pixel Pass through which customers can pay monthly subscription fees to gain access to all the services of Google and also get a new Pixel device every two years. Growth in the hardware business will help Google limit the massive increase in licensing fees it has seen in the last few years. Google’s potential in hardware business has not been priced. If the management is able to deliver strong hardware growth trajectory over the next few quarters, we should see rapid growth in earnings and valuation multiple for the company.
Google receives over 80% of its revenue from its ad business and the hardware business is a minor fraction of the over $250 billion in revenue reported by the company in the last fiscal. However, the company is in a position to deliver rapid growth in sales from this segment as new home devices are launched. According to a recent report by Omdia, Google has overtaken Amazon as the market leader in unit shipments for smart speakers in U.S.

Omdia

Omdia
Figure 1: Google overtakes Amazon in quarterly unit shipments in the smart speaker market.
We can see from the above image that the competition is heating up among tech giants to increase their market share in the smart speaker business. The total unit shipments among Apple, Google, and Amazon for the quarter was 10 million, which is equal to 40 million unit shipments on an annualized basis. The global smart speaker shipment in 2020 was estimated to be over 150 million.

Strategy Analytics

Strategy Analytics
Figure 2: Global smart speaker market share and unit shipments.
A report by Strategy Analytics confirms the market position of Google. It gives Google a 20% market share in the smart speaker segment. If we count the market share by subtracting the unit shipment in China which is mostly cornered by Chinese tech giants, the market share of Google would be even higher.
The smart speaker business is the tip of the iceberg in the smart home device segment. This segment has the potential to show a massive increase in new devices over the next few quarters. Amazon has already launched a wide range of new products which includes a robot called Astro priced at $999. Google has the resources and skills to maintain and increase the market share in these new devices.
There has been a rapid increase in licensing fees which Google pays to Apple, Samsung and other OEMs to gain access to their devices and install the app suite built by Google including Google Search, YouTube, Maps, etc. According to an earlier report by Verge, Google could be shelling as much as $40 per device to have its apps installed. WSJ has also mentioned over $10 billion paid by Google to Apple as licensing fees annually. None of the companies have openly reported the fee structure, but we can gauge the increase in licensing fee through Google’s traffic acquisition cost metric, which has risen at a rapid pace in the last few years.
Google needs to rein its licensing bill to improve the overall margins. There is also an additional issue of regulators who are looking at the licensing agreement to build an antitrust case against Google. In this scenario, the best option for Google would be to increase the sales of its own Pixel devices. This will not only give the company better control over the hardware and services offered to customers but reduce the licensing bill and regulatory challenge.
Google has already announced a doubling of production for its Pixel line in this cycle. It has also launched Pixel Pass at a very affordable subscription price which gives access to Google’s services and helps increase customer loyalty. Currently, Google is selling less than 10 million units of Pixel every year. However, a better subscription program and more attractive device prices could allow the company to increase the unit shipments significantly. Google is the most prestigious brand within Android smartphone OEMs. The growth of 5G devices is also causing a spike in average selling price for smartphones. This has reduced the price gap between Pixel and other Android devices. Over the next few product cycles, Pixel is in a very good position to grab a big chunk of the Android market which can move the needle for Google’s top line and bottom line.
The hardware business will have a halo effect on the current and future subscription services offered by Google. The management has already announced that it has over 50 million customers on YouTube Premium and YouTube Music platform. This number could increase rapidly as the company has over 2 billion unique users visiting YouTube. The company is slowly reducing the free services available to viewers and pushing them to join the subscription.

Amazon Filings

Amazon Filings
Figure 3: Growth in subscription revenue for Amazon in the last few quarters.
Subscription is a very important revenue stream as it gives recurring business and has the potential for long-term growth. Amazon has already built an enviable subscription business with a trailing twelve-month revenue of over $30 billion. Subscription business improves the ecosystem of a company and attracts customers to future services.
It is possible that Google is able to attract over 200 million paid subscribers by 2025. Even at a basic $100 average revenue per user, the subscription revenue would be more than $20 billion annually. Hardware sales growth and Pixel Pass would be some of the important drivers to improve the subscription business.
It would be difficult to move the needle on $250 billion of annual revenue for Google. However, the hardware business is an ideal segment that can improve the top line and bottom line for Google. Even after several years of diversification, Apple still receives over 80% of its sales from hardware. While the services business is driving higher multiple for Apple, the hardware business is the basis on which services are built. Hence, it would be very important for Google to ramp up its unit shipments in various hardware businesses like smart speakers, smart displays, home devices, smartphones, and others.
It should be noted that Google has lower competition within the Android ecosystem because it is one of the main U.S. tech companies offering this platform. With more attractive prices and subscription services, Google could deliver over 100 million unit shipments in Pixel over the next few years. As mentioned above, the company has a strong incentive to increase sales at all costs.

YCharts

YCharts
Figure 4: Comparison of PS ratio, PE ratio and YoY growth rate of Google, Apple and Netflix.
Google has a modest valuation multiple when compared with a hardware-oriented company like Apple or a subscription-oriented company like Netflix (NFLX). Netflix has over 200 million subscribers, but Google is showing a much faster growth rate in its YouTube subscription options. The combination of hardware, services, and subscription can make Google products more attractive to customers allowing the company greater pricing leverage and a better growth runway.
Google is focusing on its hardware products which will help the company build a stronger ecosystem. The company is already a major player in the smart speaker and smart home devices market. It has launched Pixel Pass subscription and offers attractive prices for Pixel devices which should drive the sales.
The current hardware revenue of Google is still small, but it has a long growth runway. Hardware sales will also help in reducing the licensing fees which Google pays to other OEMs and will reduce the possibility of antitrust regulations. Pixel has received good reviews and can become a key player within the Android platform by leveraging its subscription business. The hardware sales will help Google gain better valuation multiple compared to other tech companies and are one of the biggest bullish factors for the stock.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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